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Value of the firm
Value of the Firm – Samir Pipalia
The primary goal of an organization is value maximization. The value of a firm takes into account the long-term impact of managerial decisions on profits. When economists say that the goal of the firm is to maximize profits, it should be understood to mean that the firm’s goal is to maximize its value, which is the present value of current and future profits.
This value depends on various factors such as, size of a firm's free cash flows (cash flows available for distribution to all of a firm's investors after expenses and operations support for growth), it also depends on the timing of those cash flows and the risk attached to them.
Profit is simply defined as, “total revenue minus total cost”. Maximizing profits means maximizing the value of the firm, which is the present value of current and future profits. For a given interest rate and growth rate of the firm, the present value is given by,
The Present Value of the firm is the present value of the future profits (since current profits have already been paid off). The value of the firm immediately after its current profits have been paid out as dividends may be obtained by subtracting P0 from the above equation and simplified to the following formula,
Economic Profit Model
Alfred Marshall wrote as early as 1890 that the value created by a company during any time period (its economic profit) must take into account not only the expenses recorded in its accounting records but also the opportunity cost of the capital employed in business.
Since economic profit measures the value created in a company in a single period, one way to define it is:
Economic Profit = Invested Capital * (ROIC – WACC)
ROIC = the expected return on invested capital
WACC = weighted average cost of capital (which is obtained by the use of debt and/or equity by preferred stock and/or common stock, to finance)
For example, when Apple was considering bringing in the itouch into the mp3 market, based on its research, it would have invested capital of $20 million and calculated its WACC to 9% (by using debt and/or equity). The project to be undertaken if the ROIC (expected return) is greater than 9% to earn an economic profit or equal to 9% to break even. If the expected ROIC is calculated as 15%, the economic profit is for one year is calculated as,
Economic Profit = Invested Capital *(ROIC – WACC)
= 20,000,000 * (0.15 – 0.09)
= 20,000,000 * (0.06)
Value Based Management
Creating value and maximizing shareholders’ wealth is the goal of the firm. But it cannot be achieved without the management working towards that goal. The management has to constantly strive to create value for the firm. One of the ways of ensuring a balances viewpoint on potential sources of value creation is by using the Three Horizon Analysis of Growth. The Figure below describes how a firm can create value by combining these three perspectives.
The Three Horizon Analysis of Growth
includes current core businesses, which generally account for the greatest part of current profits and cash flow
includes emerging opportunities, the “rising star” businesses of the company that already have customers and revenues, even if they do not yet generate positive cash flow.
includes future options, which are opportunities where initial activity has already begun, be it a pilot project, minority stake, or memorandum of understanding.
Drivers of Value
A company that has made the decision to make value happen needs to understand what elements in its operations as well as its investment decisions have the most impact on value. The process of defining value drivers can help managers in three ways.
First, it can help both business unit managers and their staff to understand how value is created and maximized in the business. Second, it can help in prioritizing these drivers and thus in determining where resources should be placed. Third, it can align business unit managers and employees around a common understanding of top priorities.
A value driver is a performance variable that has impact on the results of a business, such as production effectiveness or customer satisfaction. Key performance indicators (KPIs) are used for target setting and for performance measurement. Two major value drivers for a company are return on invested capital and growth because they both increase the shareholders’ wealth.
Three principles are central to defining value drivers well:
Value drivers should be directly linked to shareholder value creation and cascade down throughout the organization.
a. First benefit of this value driver is that it aligns different levels of the organization to a single objective.
b. Second, it allows management to objectively balance and prioritize different value drivers as well as short-term and long-term actions.
Value drivers should be targeted and measured by both financial and operational KIPs.
Financial as well as Operational numbers are particularly useful as leading indicators that there are problems ahead. For example, a business unit’s return on invested capital may improve on a shirt-term basis because the management team is failing to maintain assets or make needed investments. Asking managers to report on operational measures such as maintenance expenses, or plans to expand or replace assets would reveal that the improvement in return on invested capital is not sustainable
Value drivers should cover long-term growth as well as operating performance.
Value driver analysis should highlight drivers to grow at a return above the cost of capital as well as drivers to improve today’s return on invested capital. For example, for a retailer it might include the number of stores to be opened in a given year or number of product categories to be introduced.
The process of value driver definition has three phases, identification, prioritization, and institutionalization.
1. If the current profits of a firm are $5000, growth rate is 5% and the interest rate is 10%. Calculate:
a. Value of the firm
b. Value of the firm immediately after it pays dividend equal to $5000
2. What are Key Performance Indicators?
a. Metrics for target settings and performance measurements
b. Weighted average costs of capital
c. Operations measures of value drivers
d. Financial measures of value drivers
3. What are two major value drivers for an organization?
b. Return on investment
c. Only a and b
e. All of the Above
4. What are the three phases of value driver definition?
d. All of the above
5. Calculate the Economic Profit for Microsoft in the first year of its release of the Windows Vista OS when the Investment Capital is $3 million, expected returns are 10%, and cost of capital is calculated as 8%. If the cost of capital were 10%, what is the expected return on investment if the economic profit for Microsoft is $100,000?
a. Key Performance Indicators are metrics for value drivers which are used for target settings and performance measurements
c. Both growth and return on investment drive the shareholders’ wealth and are of major concern for a manager.
d. Key value drivers need to be identified, prioritized in order of importance and then need to be incorporated into the targets.
Baye, Michael R.,
Managerial Economics and Business Strategy
. Fourth Edition. McGraw Hill. Pg. 15-17
Brigham, Eugene, F. and Ehrhardt, Michael, C.,
. Thomson South-Western. Pg. 12, 33, 39-46
The Economic Way of Thinking.
Seventh Edition. Macmillan College Publishing Company. Pg 278
McKinsey & Company, Inc, Copeland, T., et. al.,
Valuation Measuring and Managing the Value of Companies.
Third Edition. John Wiley & Sons, Inc. Pg. 95, 97-99, 143-145
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